risk as the starting point to asset allocation · risk as a starting point to asset allocation...

MEAI Summit

February 18, 2009

Risk as the Starting Point to Asset Allocation

Risk as the Starting Point to Asset Allocation

Yaser AbuShaban, CFAVice President & Senior Portfolio ManagerTreasury & Investments

Yaser AbuShaban, CFAVice President & Senior Portfolio ManagerTreasury & Investments

2008

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AGENDA

Traditional Asset Allocation

Risk as a Starting Point to Asset Allocation

Conclusion

The Role of Alternatives in a portfolio

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ADDING DIVERSIFICATION

2008 2006 2002 2001 2000

MSCI AC World -40.9% 14.4% -24.6% -14.4% -11.7%

S&P 500 -38.5% 13.6% -23.4% -13.0% -10.1%

MSCI Europe -45.5% 16.5% -32.2% -16.9% -3.6%

MSCI Emerging Markets -47.3% 25.6% -9.1% 5.1% -26.6%

MSCI Arabian Markets -55.0% -40.4% N/A N/A N/A

JP Morgan Global Bond 9.4% 3.1% 8.4% 6.2% 10.8%

JP Morgan US Govt Bonds 14.3% 3.1% 12.2% 6.6% 13.9%

JP Morgan EMBI Global -10.9% 9.9% 13.1% 1.4% N/A

ML US Corporate Master -10.9% 9.9% 13.1% 1.4% N/A

GS Commodity Index -46.5% -15.1% 32.1% -31.9% 49.9%

WTI Crude Oil -53.5% 0.2% 57.3% -26.0% 4.7%

Gold 5.8% 23.2% 24.8% 2.5% -5.5%

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ADDING DIVERSIFICATION

2008 2006 2002 2001 2000

CS Hedge Fund Index -19.1% 13.9% 3.1% 4.4% 4.8%

CS Long/Short Equity -19.7% 14.4% -1.6% -3.7% 2.1%

CS Multi-Strategy -16.2% 16.4% 1.2% 6.8% 11.8%

CS Emerging Markets -30.4% 20.5% 7.4% 5.9% -5.5%

CS Fixed Income Arbitrage -28.8% 8.7% 5.7% 8.0% 6.3%

CS Event Driven -17.7% 15.8% 0.2% 11.5% 7.2%

CS Distressed -20.5% 15.6% -0.7% 20.0% 1.9%

CS Global Macro -4.6% 13.5% 14.7% 18.4% 11.7%

CS Managed Futures 18.3% 8.1% 18.3% 1.9% 4.3%

CS Dedicated Short Bias 14.9% -6.6% 18.2% -3.6% 15.8%

CS Convertible Arbitrage -31.6% 14.3% 4.0% 14.6% 25.7%

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IDENTIFYING SPECIAL SITUATIONS

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IDENTIFYING SPECIAL SITUATIONS

CDS Spreads

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Jun-08 Jul-08 Sep-08 Oct-08 Dec-08 Feb-09 Mar-09

(bp

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UK KSA Abu Dhabi McDonald's

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CAPITALIZING ON VOLATILITY

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AGENDA



Conclusion


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TRADITIONAL ASSET ALLOCATION

The goal of the asset allocation process is to select an “optimal” portfolio of assets given an investor’s risk tolerance and capital market expectations

Set Return Target

Identify Acceptable

Asset Classes

Historical Mean/Variance

Optimization

Define Risk Tolerance

Policy Portfolio/Strategic Asset

Allocation

Overlay Capital Markets Expectations

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MODERN PORFOLIO THEORY (MPT) & MEAN/VARIANCE OPTIMIZATION (MVO)

• The Theory behind MOV is based on Modern Portfolio Theory (MPT)

first developed by Harry Markowitz in 1950s

• MPT is based on highly stylized assumptions that lead to a very

elegant theoretical solution but are somewhat divorced from reality:

–All investors are rational and have similar expectations

–Standard deviation is the perfect proxy for risk

–Investors can borrow at the risk free rate (no credit risk)

• As a result, any asset or asset class can be fully characterized by its

risk, represented by price volatility, and its return

• In this stylized world, portfolios of assets are optimized and

diversification benefits precisely captured through MVO

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•MPT requires formulating forecasts of asset volatility and return levels to use as inputs into the MVO

process

•In practice historical MVO is widely applied–Assumes historical returns are indicative of future returns–Assumes historical volatilities are good forecasts for future

risk–Assumes asset class correlations are stable over time

MODERN PORTFOLIO THEORY & MEAN/VARIANCE OPTIMIZATION (MVO)

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THE MEAN/VARIANCE OPTIMIZED PORTFOLIO

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LIMITATIONS OF HISTORICAL MEAN/VARIANCE OPTIMIZATION (MVO)

Historical MVO can result in over allocating to yesterday’s winners, resulting in lower ex-postreturns and diversification in the portfolio

–Optimization is very sensitive to historical time period

used to generate return and volatility estimates

–Asset class returns can go through periods of sustained

out or under performance

–Asset class correlations can be unstable and time

variant

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3-year rolling Correlation of US Stocks to US Bonds (1990-2007)

HISTORICAL CORELLATIONS ARE UNSTABLE

Source: Bridgewater Associates

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AMENDING THE FINE PRINT

Disclaimer:Past investment performance is not

indicative and cannot assure nor

guarantee future investment returns,

except when it comes to the

formulation of investment policy

statements, and the historical mean-

variance optimization of investment

portfolios.

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THE POLICY PORTFOLIO TRAPOptimal US Portfolio Example: 1980s vs. 1990s

1980s Optimal Portfolio

1.0012%12%34%Bonds

1.6610.5%17.4%100%Total Portfolio

N/A0%9%4%Cash

1.1216%18%15%US Stocks

1.2218%22%47%Non-US Stock

Info. RatioRiskReturnAllocation

1990s Optimal Portfolio

2.004%8%25%Bonds

1.4510.5%15.2%100%Total Portfolio

N/A0%5%0%Cash

1.2914%18%75%US Stocks

0.3918%7%0%Non-US Stock

Info. RatioRiskReturnAllocation

Source: National Association of Business Economics, USA, 2003

International stock returns are from the MSCI EAFE index, US stock returns are from Standard & Poors 500 Index, and bond returns are from the JPM US

government bond index. Cash returns are on 3-month Treasury bills.

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1 Apr 2008–31 Mar 2009

Business plans

0.56Info. Ratio

12.0%Risk

6.7%Return

THE POLICY PORTFOLIO TRAPOptimal US Portfolio Example: 1980s vs. 1990s (Continued)

1980s Optimal Portfolio Held Through 1990s

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AGENDA

Risk as a Starting Point to Asset

Allocation

Conclusion


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WHAT IS RISK?

The possibility of not achieving a given target

Expressions of Risk:

• Volatility • Market risk• Short-fall risk• Value-at-Risk• Sovereign risk• Counter-party risk• Credit risk• Operational Risk• Model risk• Liquidity risk• Career risk

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INVESTMENT RISK IS UNAVOIDABLE

“Risk itself is not something to be avoided. Wealth creation depends on taking risk, on allocating that risk across many assets, on being patient, and on being willing to accept short-term losses while focusing on long-term return. . . . In an investment portfolio, risk is necessary to drive return. . . . Risk should be viewed as a scarce resource that needs to be used wisely. Risk should be budgeted, just like any other resource in limited supply”.

-- Dr. Robert Litterman, Managing Director, Goldman SachsFrom “Modern Investment Management: An Equilibrium Approach”, (Hoboken, NI: John Wiley & Sons, Inc., 2003), p.7.

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Business plans

ALLOCATING A RISK BUDGET

•Risk is a scarce resource

•Should target maximizing returns for unit of risk taken

• In Traditional Asset Allocation, risk “falls out” of the Asset Allocation instead of driving it

•Even when a target risk level is set for the over all portfolio,individual asset class risk-adjusted returns are not considered

•More emphasis placed on the long-term historical returns of an asset class, leads to more risk being allocated to asset classeswith higher absolute historical returns but similar or lower risk-adjusted returns

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EXAMPLE: THE IMPACT OF EQUITIES RISK IN CONVENTIONAL INSTITUTIONAL PORTFOLIOS

Portfolio Composition:- Global Public and Private Equity: 60%- Nominal Bonds: 25%- Commodities, Real Estate, Inflation Linked Bonds

and Cash: 15%

Risk Composition:- Global Public and Private Equity: 92%- Nominal Bonds: 3%- Commodities, Real Estate, Inflation Linked Bonds

and Cash: 5%

Source: Bridgewater Associates simulated analysis (1970 – 2007)

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EXAMPLE: THE IMPACT OF EQUITIES RISK IN CONVENTIONAL INSTITUTIONAL PORTFOLIOS

Source: Bridgewater Associates simulated analysis (1970 – 2007)

Inefficient allocation of the risk budget: In a portfolio with 60% allocation to

Equities, 92% of the downside variation comes from the Equities exposure

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THE RISK-RETURN CONTINUEM REVISTED

• There is a positive relationship between risk and return

• On a risk-adjusted basis, asset classes have similar long-term returns

• Achieving a higher return target requires a bigger risk budget

• More risk need not mean bigger allocations to riskier assets…

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Business plans

LEVERAGE AND REPACKAGING RISK

• One of the corollaries of MPT is

investors’ ability to “lever-up” by

borrowing at the risk free rate and

investing in the optimal market portfolio,

thereby achieving “super optimal”

returns but at higher risk levels (i.e.

higher absolute returns but similar risk

adjusted returns)

• Investors can use leverage to increase

the risk (and expected return) of less

risky assets, and can de-lever (hold

more cash) to reduce the risk of more

risky assets

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LEVERAGE AND REPACKAGING RISK

Source: Bridgewater Associates simulated excess returns over cash

(1970 – 2007)

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THE BENEFITS OF A RISK-BASED ASSET ALLOCATION

•Asset class with different expected returns and risk, can have their returns adjusted via levering and de-levering to produce similar yield and risk levels

•The choice of an asset class is no longer driven by absolute expected return, since all asset classes would have leverage applied to yield similar returns

•The asset allocation decision is now driven by two factors:

–Diversification benefit: Combining low-correlation assets

–Economic environment and market forecasts: Active rebalancing in line with economic cycles and macro environments, with more risk allocated to assets expected to perform better in the current cycle

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Business plans

IMPROVED DIVERSIFICATION

Conventional Portfolio Risk Impact New Portfolio Risk Impact

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•Separation of active (alpha) and passive (beta) risk

•Creating portable alpha strategies by allocating

more risk to the “best” managers in the portfolio and “porting” that alpha on to passive exposures

•Creating alternative “beta” strategies by rebalancing

passive exposures between asset class based on

return and economic cycle forecasts

COROLLARIES OF RISK-BASED ASSET ALLOCATION – MORE ADVANCED TOPICS

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AN EXAMPLE: “PORTING” ALPHA

• Manager 1: Equities Manager, 16% return, 2% alpha

• Manager 2: Fixed Income Manager, 8% return, 5% alpha.

• Clearly, more risk should be allocated to the manager with higher alpha

• Better-off to terminate Manager 1 and get passive exposure to equities, while levering up to gain more exposure to Manager 2

• “Port” Fixed Income Alpha onto Equities

3%

14%

5%

2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Manager 1 Manager 2

Re

turn

Beta Alpha

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AGENDA


Conclusion


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CONCLUSION

The goal of the asset allocation process is to select an “optimal” portfolio of assets given an investor’s risk tolerance and capital market expectations

Set Risk Budget

Allocate Risk to Asset Classes

Optimize to Maximize

Diversification Benefits

Set Return Objective

Policy Portfolio/Strategic Asset

Allocation

Overlay Capital Markets Expectations

Risk-Based Asset Allocation: Same Goal Better Achieved

risk as the starting point to asset allocation · risk as a starting point to asset allocation...

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